Hybrid and

Derivative
Securities

Overview of Hybrids and

Derivatives
A hybrid security is a form of debt or equity financing that
possesses characteristics of both debt and equity financing.
Examples include
preferred stock
financial leases
convertible securities
stock purchase warrants.

A derivative security is a security that is neither debt nor

equity but derives its value from an underlying asset that is
often another security; called derivatives, for short.
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Leasing
Leasing is the process by which a firm can obtain the use of
certain fixed assets for which it must make a series of
contractual, periodic, tax-deductible payments.
The lessee is the receiver of the services of the assets under
a lease contract.
The lessor is the owner of assets that are being leased.

Leasing: Types of Leases

An operating lease is a cancelable contractual arrangement whereby
the lessee agrees to make periodic payments to the lessor, often for 5
or fewer years, to obtain an assets services; generally, the total
payments over the term of the lease are less than the lessors initial
cost of the leased asset.
A financial (or capital) lease is a longer-term lease than an operating
lease that is noncancelable and obligates the lessee to make payments
for the use of an asset over a predefined period of time; the total
payments over the term of the lease are greater than the lessors initial
cost of the leased asset.
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Leasing: Leasing Arrangements

A direct lease is a lease under which a lessor owns or acquires the
assets that are leased to a given lessee.
A saleleaseback arrangement is a lease under which the lessee sells
an asset to a prospective lessor and then leases back the same asset,
making fixed periodic payments for its use.
A leveraged lease is a lease under which the lessor acts as an equity
participant, supplying only about 20 percent of the cost of the asset,
while a lender supplies the balance.
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Leasing: Leasing Arrangements

(cont.)
Maintenance clauses are provisions normally included in an
operating lease that require the lessor to maintain the assets and to
make insurance and tax payments.
Renewal options are provisions especially common in operating
leases that grant the lessee the right to re-lease assets at the expiration
of the lease.
Purchase options are provisions frequently included in both operating
and financial leases that allow the lessee to purchase the leased asset
at maturity, typically for a prespecified price.
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Leasing: Lease-versusPurchase Decision

The lease-versus-purchase (or lease-versus-buy) decision
is the decision facing firms needing to acquire new fixed
assets: whether to lease the assets or to purchase them, using
borrowed funds or available liquid resources.

Leasing: Lease-versusPurchase Decision

The lease-versus-purchase decision involves application of capital
budgeting techniques. First, we determine the relevant cash flows and
then apply present value techniques. The following steps are involved
in the analysis:
Step 1
Find the after-tax cash outflows for each year under the lease
alternative. This step generally involves a fairly simple tax adjustment
of the annual lease payments. In addition, the cost of exercising a
purchase option in the final year of the lease term must frequently be
included.
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Leasing: Lease-versusPurchase Decision (cont.)

Step 2
Find the after-tax cash outflows for each year under the purchase
alternative. This step involves adjusting the sum of the scheduled loan
payment and maintenance cost outlay for the tax shields resulting
from the tax deductions attributable to maintenance, depreciation, and
interest.

Leasing: Lease-versusPurchase Decision (cont.)

Step 3
Calculate the present value of the cash outflows associated with the
lease (from Step 1) and purchase (from Step 2) alternatives using the
after-tax cost of debt as the discount rate. The after-tax cost of debt is
used to evaluate the lease-versus-purchase decision because the
decision itself involves the choice between two financing techniques
leasing and borrowing.
Step 4
Choose the alternative with the lower present value of cash outflows
from Step 3. It will be the least-cost financing alternative.

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Leasing: Lease-versusPurchase Decision (cont.)

Roberts Company, a small machine shop, is contemplating acquiring a
new machine that costs P24,000. Arrangements can be made to lease
or purchase the machine. The firm is in the 40% tax bracket.
Lease The firm would obtain a 5-year lease requiring annual end-ofyear lease payments of P6,000. All maintenance costs would be paid
by the lessor, and insurance and other costs would be borne by the
lessee. The lessee would exercise its option to purchase the machine
for P4,000 at termination of the lease.

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Leasing: Lease-versus-Purchase
Decision (cont.)
Purchase The firm would finance the purchase of the machine with a
9%, 5-year loan. The machine would be depreciated for 5 years. The
firm would pay P1,500 per year for a service contract that covers all
maintenance costs; insurance and other costs would be borne by the
firm.
What is the annual end-of-year installment?

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Leasing: Lease-versus-Purchase
Decision (cont.)
Purchase The firm would finance the purchase of the machine with a
9%, 5-year loan. The machine would be depreciated for 5 years. The
firm would pay P1,500 per year for a service contract that covers all
maintenance costs; insurance and other costs would be borne by the
firm.

*Annual lease payment = P24,000 PVIFA 9%, 5= P6,170

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Leasing: Lease-versus-Purchase
Decision (cont.)
Step 1: Find the after-tax cash outflows for the lease option
After-tax cash outflow from lease = P6,000 (1 T)
= P6,000 (1 0.40) = P3,600
Year

After-tax Cash Outflows

P3,600

3,600

3,600

3,600

3,600 + 4,000 = 7,600

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Determining the Interest and Principal

Components of Roberts Company Loan
Payments
Step 2: Find the after-tax cash outflows for the purchase option
through the 9% 5-year loan

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After-Tax Cash Outflows Associated with

Purchasing for Roberts Company

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Comparison of Cash Outflows Associated with

Leasing versus Purchasing for Roberts
Company
Step 3: Compare cash outflows of both options

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Leasing: Lease-versusPurchase Decision (cont.)

Step 4: Choose the lower-cost financing option
Because the present value of cash outflows for leasing
(P18,491) is lower than that for purchasing (P19,631), the
leasing alternative is preferred. Leasing results in an
incremental savings of P1,140 (P19,631 P18,491) and is
therefore the less costly alternative.

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Advantages and Disadvantages

of Leasing

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Advantages and Disadvantages

of Leasing

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Convertible Securities
A conversion feature is an option that is included as part of a bond or
a preferred stock issue and allows its holder to change the security into
a stated number of shares of common stock.
The conversion feature typically enhances the marketability of an issue.

Because the conversion feature provides the purchaser with the

possibility of becoming a stockholder on favorable terms, convertible
bonds are generally a less expensive form of financing than similarrisk nonconvertible or straight bonds.

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Convertible Securities: General

Features of Convertibles
The conversion ratio is the ratio at which a convertible security can
be exchanged for common stock.
The conversion ratio can be stated in two ways:
1. Sometimes the conversion ratio is stated in terms of a given
number of shares of common stock. To find the conversion price,
which is the per-share price that is effectively paid for common
stock as the result of conversion of a convertible security, divide
the par value of the convertible security by the conversion ratio.
Example: Smart Inc., a manufacturer of denim products, has
outstanding bond that has a P1,000 par value and is convertible
into 25 shares of common stock. The bonds conversion ratio is
25. The conversion price for the bond is P40 per share (P1,000
25).
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Convertible Securities: General

Features of Convertibles (cont.)
2. Sometimes, instead of the conversion ratio, the conversion price
is given. The conversion ratio can be obtained by dividing the par
value of the convertible by the conversion price.
Example: Mosher Company, a franchiser of seafood restaurants,
has outstanding a convertible 20-year bond with a par value of
P1,000. The bond is convertible at P50 per share into common
stock. The conversion ratio is 20 (P1,000 P50).

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Convertible Securities: General

Features of Convertibles (cont.)
The conversion (or stock) value is the value of a convertible security
measured in terms of the market price of the common stock into which
it can be converted.
McNamara Industries, a petroleum processor, has outstanding P1,000
bond that is convertible into common stock at P62.50 per share. The
conversion ratio is therefore 16 (P1,000 P62.50). Because the
current market price of the common stock is P65 per share, the
conversion value is P1,040 (16 P65). Because the conversion value
is above the bond value of P1,000, conversion is a viable option for
the owner of the convertible security.

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Convertible Securities: General

Features of Convertibles (cont.)
Contingent securities include convertibles, warrants, and stock
options. Their presence affects the reporting of a firms earnings per
share (EPS).
Firms with contingent securities, that if converted or exercised would dilute
(that is, lower) earnings per share, are required to report earnings in two
waysbasic EPS and diluted EPS.
Basic EPS are earnings per share (EPS) calculated without regard to any
contingent securities.
Diluted EPS are earnings per share (EPS) calculated under the assumption
that all contingent securities that would have dilutive effects are converted
and exercised and are therefore common stock.

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Convertible Securities:
Financing with Convertibles
Convertibles can be used for a variety of reasons:
As a form of deferred common stock financing
As a sweetener for financing
To raise cheap funds temporarily

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Stock Purchase Warrants:

Key Characteristics
A stock purchase warrant is an instrument that gives its
holder the right to purchase a certain number of shares of
common stock at a specified price over a certain period of
time.
Warrants are often attached to debt issues as sweeteners.
Often, when a new firm is raising its initial capital, suppliers of
debt will require warrants to permit them to share in whatever
success the firm achieves.
In addition, established companies sometimes offer warrants
with debt to compensate for risk and thereby lower the interest
rate and/or provide for fewer restrictive covenants.
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Stock Purchase Warrants:

Key Characteristics (cont.)
The exercise (or option) price is the price at which holders
of warrants can purchase a specified number of shares of
common stock.
If the market price of the stock is less than the exercise price,
holders of warrants will not exercise them, because they can
purchase the stock cheaper in the marketplace.

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Stock Purchase Warrants:

Key Characteristics (cont.)
Comparison of Warrants to Stock Rights
Both result in new equity capital.
The life of a right is typically not more than a few months; a
warrant is generally exercisable for a period of years.
Rights are issued at a subscription price below the prevailing
market price of the stock; warrants are generally issued at an
exercise price 10 to 20 percent above the prevailing market
price.

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Stock Purchase Warrants:

Key Characteristics (cont.)
Comparison of Warrants to Convertibles
The exercise of a warrant shifts the firms capital structure to a
less highly levered position because new common stock is
issued without any change in debt. If a convertible bond were
converted, the reduction in leverage would be even more
pronounced, because common stock would be issued in
exchange for a reduction in debt.
In addition, the exercise of a warrant provides an influx of new
capital; with convertibles, the new capital is raised when the
securities are originally issued rather than when they are
converted.
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